The Eurozone crisis will not go away until banks face reality

European regulators have turned risk assessment into an insider’s game where the bankers are calling the shots.

FORTUNE — The European sovereign debt crisis is slowly driving the global economy back into the ditch. Why is this crisis so unresolvable? The answer comes back once again to excess risk taking and leverage in the banking sector. In late October, Europe’s leaders finally persuaded the banks to take a 50% cut on the Greek debt they hold. But debt restructuring will get you only so far because Europe’s banks do not have sufficient capital to absorb future losses, which the IMF estimates will be $280 billion or higher. And why are Europe’s banks so thinly capitalized? That responsibility rests squarely with European banks and their regulators.

When bank regulators assess the adequacy of a bank’s capital to handle losses from its loans, investments, and other assets, they take into account the riskiness of those assets. For instance, an investment in U.S. Treasuries carries lower risk (we hope) than an unsecured credit card line. The process, however, is more art than science, and in Europe regulators have given their banks much more leeway in making those determinations than banks have in the U.S. As a result, since the mid-1990s European banks have continually lowered their estimates of likely losses on their assets and now say their assets are twice as safe as those held by U.S. banks.

The problem has been exacerbated by Europe’s adoption of a complex Basel II methodology, which essentially lets bank managers use their own judgment in determining the riskiness of their assets. That is naive. It is in a bank manager’s interest to say his assets have low risk, because it enables the bank to maximize leverage and return on equity, which in turn can lead to bigger pay and bonuses. Indeed, even during the Great Recession, as delinquencies and defaults increased, most European banks were saying their assets were becoming safer.

The U.S., which has tighter rules governing how FDIC-insured banks determine the riskiness of assets, requires well-capitalized banks to hold capital equal to at least 5% of total assets, regardless of how risky they think the assets are. So for any asset, be it cash, U.S. Treasury securities, or supposedly safe mortgages, banks must hold at least 5% capital against it. European banks do not have this kind of “leverage ratio,” and Basel II has allowed them to treat sovereign debt as having zero risk. That is one of the main reasons they have loaded up on nearly $3 trillion of it.

Last year the Basel Committee on Banking Supervision finally approved a still-too-low 3% international leverage ratio. Even at that permissive level, the committee’s own research suggests that more than 40% of the world’s largest banks would have to raise capital. At the same time, the European Banking Authority (EBA) is raising European banks’ common equity capital requirement to 9%, a huge jump from the Basel II standard of 2% and roughly equivalent to the new Basel III standards. But even at 9%, a large number of European banks will continue to operate at extreme levels of leverage because of their rosy views of risk.

European regulators should supplement this requirement with the Basel III 3% leverage ratio — or even better, the U.S. 5% requirement, adjusting for accounting differences. The EBA should also use realistic loss estimates more in line with those of the IMF and private analysts. If banks have to accept dilution of their stock or temporary nationalization, so be it.

The Basel committee needs to move swiftly to adopt standardized measures of risk set by regulators, not banks, and to consistently apply them across all institutions. U.S. regulators made many mistakes, but because we maintained our leverage ratio and delayed Basel II implementation, FDIC-insured banks have remained much more stable than other financial institutions. Bank capital standards should not be an insider’s game. The public deserves better. Bank regulators should do their job, and it is their job, not the job of conflicted bank managers, to set minimum capital levels.

This article is from the November 21, 2011 issue of Fortune.

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